With a Bang or a Whimper?

10/20/2008 12:01 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

Where will this all end, with a bang, or a whimper? 

I’m betting on the Big Bang theory—a burst of inflation down the road. During this entire financial crisis, I’ve believed that the global central banks will never let the system end in deflation, with assets losing value and wealth going down the drain of write offs. Not while they had the power to print!

That view was backed up by Treasury Secretary Henry Paulson’s comments earlier this week that the United States had multiple “balance sheets” policy makers could use to create liquidity for the system—not only the Treasury, but the Federal Reserve, Fannie Mae and Freddie Mac, and now the banks themselves. 

In other words, there’s really no limit to the amount of money that can be created to get the global system going again. And other central banks certainly agree.

I’ve often referred to our liquidity problems as a bathtub. Falling asset values are the water swirling down the drain, while the Fed and the Treasury are turning on the spigots full blast to replace the money going down the drain and to keep the water level and at just the right temperature! While the water level has gotten low in recent weeks, it appears they’re managing to refill the tub quickly.

Now the big question is: if they’re successful, will they know it? Or will they keep the taps open full force, causing the tub to eventually spill over?

For perspective, let’s stipulate that in micro- or macro-managing the economy, the Fed and Treasury have never gotten it exactly right! It’s an impossible task. Right now, the global markets are preoccupied with stopping deflation. After all, there are still mountains of credit default swaps and other bad debt to unwind, and we haven’t begun to see the impact of a recession on consumer balance sheets, and credit card debt, auto loans, commercial real estate, what have you.

But down the road, someone will tote up the money that’s already been created, and is yet to be created, to deal with this crisis. Not to mention the money that’s been borrowed, and is yet to be borrowed—officially more than $11 trillion—to keep the water flowing into the bathtub. 

And then they’ll ask: “What’s all this paper money (bank credit) really worth?”

On that day, investors will be looking for an asset that holds its value when paper and promises are shredded. Gold, anyone?

What do you think? Have your say by writing a comment now.

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